Deutsche Bank: The Biggest Gray Swan Always Does The Most Damage
European banking collapse with immediate global contagion (ground zero: Deutsche Bank)
Prevailing Gray Swans: The Clear and Present Danger List for the Week Ending September 9, 2016
1. European banking collapse with immediate global contagion (ground zero: Deutsche Bank)
Deep Background and Threat Forensics: Briefing Focus
[economics | finance | politics | sociology]
The Lehman (LEH) collapse in 2008 was one of the primary causes of the global banking crisis and has been labeled as “a Lehman moment”. LEH suffered huge losses accrued in sub-prime mortgage-backed securities throughout 2008 and reported losses of USD 2.8B in its fiscal second quarter.
LEH’s bankruptcy on September 15, 2008 caused a global contagion from the intricacy, interconnectedness and scale of counterparty risks throughout the global banking system which required an immediate bail-out of multiple “too-big-too-fail” banks from the coordinated efforts of the world’s central banks to prevent absolute collapse and loss of confidence.
Fast forward to today…
DB’s derivative exposure is the largest in the world and poses a threat many-fold that of LEH due to its scale:
and due to its vast interconnectedness:
and also DB’s contribution to systemic risk:
Global regulatory agencies (“watchdogs”) have reported the following eight major findings on DB in 2016:
- International Monetary Fund: DB is the most important net contributor to systemic risks in the world (source: IMF report on Germany, June 2016, pp. 29–31).
- US Federal Reserve Board: DB failed qualitative stress test (one of two banks in the world to fail (2nd is Banco Santander)) (source: June 2016 FRB report, 11 references to DB in report).
- Moody’s credit agency: On May 23, 2016 Moody’s downgraded DB’s credit evaluation from Baa1 to Baa2; its long term creditworthiness for deposits from A3 from A2; and counterparty risk assessment to A3(cr) (source:Moody’s Rating Action report on 5/23/2016).
- Financial Industry Regulatory Authority (FINRA) and Securities and Exchange Commission (SEC): DB failed to submit “blue sheet” documents on over 1 million trades. FINRA and the SEC regularly request certain trade data, also known as “blue sheets,” to assist in the investigation of market manipulation and insider trading.
FINRA found that from at least 2008 through at least 2015, Deutsche Bank experienced significant failures with its blue sheet systems used to compile and produce blue sheet data, including programming errors in system logic and the firm’s failure to implement enhancements to meet regulatory reporting requirements. These failures caused the firm to submit thousands of blue sheets to regulators that misreported or omitted critical information on over 1 million trades.
Additionally, FINRA found a significant number of Deutsche Bank’s blue sheet submissions did not meet regulatory deadlines. Firms typically have 10 business days to respond to a blue sheet request. Between January 2014 and August 2015, approximately 40 percent of Deutsche Bank’s blue sheets were filed past the regulatory deadline; and likewise, from July to August 2015, more than 90 percent of Deutsche Bank’s blue sheets were not submitted to FINRA on a timely basis.
(Source: FINRA News Release on June 29, 2016)
5. US District Court, Southern District of New York: DB settles in class action suit for price fixing manipulation of precious metals exchanges (gold and silver futures and options litigation). Sources: Reuters April 14, 2016 | Court document A | Class action settlement information).
6. US Department of Justice: DB to settle allegations that its traders were among those that conspired to rig currency rates.
Deutsche Bank is the biggest global foreign-exchange trader that hasn’t reached a deal with the U.S. Department of Justice to settle allegations that its traders were among those that conspired to rig currency rates. JPMorgan Chase & Co., Citigroup Inc.’s Citicorp and four others agreed to pay a total of $5.8 billion and enter guilty pleas in connection with the currency-rigging probe.
The world’s biggest lenders generated $9.5 billion in revenue in 2015 from helping clients buy and sell the most heavily traded currencies.
(Source: Bloomberg, June 6, 2016, “Deutsche Bank Currency Trading Chief Arinc Leaving the Firm”)
7. US Department of Justice: DB Group Services (UK) Limited, a wholly owned subsidiary of Deutsche Bank AG, agreed to plead guilty to wire fraudfor its role in manipulating LIBOR, a leading interest rate benchmark used in financial products and transactions around the world. (Source: US Dept of Justice: Antitrust Department, April 11, 2016)
8. DB and Credit Suisse are both being delisted from the EURO STOXX 50 Index, Europe’s leading Blue-chip index for the Eurozone. Resultantly, there will be obligatory selling of very large equity positions of DB from many portfolios like insurance companies and pensions due to fiduciary guidelines and mandates. This will increase their leverage ratios and trigger more risk red flags than mentioned above by manifold regulatory agencies. However, given the extraordinary political gravity of systemic ramifications, whether they will perform their regulatory function and execute downgrades is unknown.
Exclusion from a benchmark generally means that exchange-traded funds and other passive investors that track the index will be forced to sell the shares.
(Source: Reuters, August 2, 2016)
This is the outcome of all the litigation costs so far from the multiple regulatory findings (others are in progress):
The bank’s latest quarterly earnings, released today (July 27), beat analysts’ (low) expectations in part because of reduced litigation charges. Still, the bank’s report spent nine pages and more than 6,000 words to explain all of its various ongoing legal entanglements. The word “litigation” was mentioned on the conference call with executives this morning more times than “profit” and “income” combined. “Indeed we do assume that there will be some additional litigation charges in the second half of the year,” said CFO Marcus Schenck. “Quantifying that, as we’ve always highlighted, is very tricky. We think they could potentially be material.”
(Source: qz.com, July 27, 2016, “Deutsche Bank promises that this is the last year it will waste so much money on legal fines”)
Potentially catastrophic damage to DB’s net derivatives positions from the surprising Brexit result:
Unlike 2008 when LEH suffered massive losses due to the collapse of the housing bubble via sub-prime mortgage-backed derivatives, derivatives exposure during the current banking crisis is about currencies: currency swaps and their interest rates.
The interest rate segment accounts for the majority of OTC derivatives activity. For single-currency interest rate derivatives at end-December 2014, the notional amount of outstanding contracts totalled $505 trillion, which represented 80% of the global OTC derivatives market (Table 3). At $381 trillion, swaps account for by far the largest share of outstanding interest rate derivatives.
On June 24, 2016 during the Brexit vote, statistically aberrant events occurred in Forex exchange rates that were the greatest in the history of finance greatly exceeding the 2008 collapse. It is impossible to hedge against 6-sigma (standard deviations) moves let alone a 12-sigma black swan shock. Like in New Orleans, the Corp of Army Engineers “hedged” against a Category 3 hurricane at landfall but the walls were not tall enough to avoid flooding opposing a Category 4 or 5 like Katrina. The same predicament occurred for protecting the Fukushima Daiichi nuclear disaster in 2011: the walls were inadequate for a tsunami of that many more standard deviations than what was estimated to be a logical balance between historical likelihood and cost to defend. What struck the global derivatives books was a tsunami of biblical proportion. Not only DB was in the crosshairs, many GSIB banks were. Banks that were on the wrong side of mega-back swan derivatives trades took on more water. The banking system today, unlike 2008, was still damaged from 2008 and the European debt crisis of 2011. European banks in particular could not afford any more shocks rapidly affecting currency exchange rates and huge fluctuations in sovereign debt (bonds) interest rates.
And putting Brexit in historical perspective:
It is not publicly known what the exact derivative positions were of the GSIB member banks pre- and post-Brexit. What is known, however, is that George Soros and Marshall Wace, a London-based hedge fund, both took large short positions after — not before — Brexit. This is not speculation because extremely large short positions must be registered into the public record.
George Soros, who became known as the man who broke the Bank of England with a bet against the British pound in 1992, made a multimillion-dollar wager against Deutsche Bank after the British vote to leave the European Union.
His Soros Fund Management took a short position of 0.51 percent of the bank’s stock on Friday, when the referendum results were announced.
Marshall Wace, a London-based hedge fund, took a similar position that day.
Both moves were disclosed in regulatory filings in Germany, where investors are required to disclose their short positions once they hit a threshold.
(Sources: NY Times, June 28, 2016, “Hard-to-Sell Assets Complicate European Banks’ ‘Brexit’ Risks”) | Die Welt (trans. German) “George Soros is betting 100 million euros against German bank”)
Analysis of the trade: DB stock fell 90% between the 2007 high and the date of taking the short position (June 25, 2016). On the surface, this is an extremely unwise move because the majority of the potential upside to the trade has expired. Out of context this is a classic rookie mistake, a textbook example of what not to do. So why take the gamble? Because between an entry point of USD 14.72 (close on 6/25/16) and a decline to October 2008 LEH level lies a return of 90% — from there! Do George Soros and Marshall Wace, two very astute and savvy investors with large intelligence networks, know something you do not? There is a strong possibility that they knew DB’s derivatives positions prior to Brexit and then made the trade post-Brexit after knowledge of the referendum’s fate. Also, they would know about the mandatory EURO STOXX 50 delisting and its damage to the stock price as it dropped into single digits from the headline news and, from there, the descent into penny-stock LEH range which is epic pay-dirt for this trade dynamic. Intelligence constructs context and context reframes the risk-return scenario due to dramatic increases of the signal-to-noise ratio: intel trumps charts 100% of the time. But, in this case, the charts do not contradict.
Factor: Less than two weeks post-Brexit DB’s head of foreign exchange and emerging market debt trading, Ahmet Arinc, is leaving the company, according to a memo to staff. (Source: Bloomberg, July 6, 2016, “Deutsche Bank Currency Trading Chief Arinc Leaving the Firm”)
Factor: The temperature of bank’s health is indicted by the given bank’s credit default swaps derivatives (CDS, what hockey-sticked in The Big Short) and contingent convertible capital instrument (CoCo bonds) which have been called “high yield bonds with a grenade attached.”
Comparison of DB to other globally-systemic important banks as of August 19, 2016:
Evidence of potential liquidity issues (impacts leverage and systemic risk)
Deutsche Bank and UniCredit are most likely among European banks to struggle to pay coupons on their Additional Tier 1 bonds, analysts at Morgan Stanley said, suggesting more may need to be done to strengthen balance sheets.
AT1 bonds — dubbed contingent capital, or CoCos — convert into shares or are wiped out, sometimes temporarily, if a bank’s capital falls below a certain level and are intended to provide an extra cushion of capital for banks. Concerns over capital-constrained banks’ ability to pay coupons was heightened in February when the value of Deutsche Bank’s AT1s fell sharply on fears it lacked sufficient available distributable items (ADI), which determine the payment of AT1 coupons.
Deutsche rejected those worries, but concerns persist it needs to raise billions of euros of equity to strengthen its capital.
“The ability of issuers to service AT1 coupons will remain a central risk that ideally should be quantified,” Morgan Stanley analysts Greg Case and Jackie Ineke said in a research note.
“While there are many variables that will determine this risk, the key is capital — specifically CET1,” they said, referring to common equity ratios. Deutsche Bank ranked bottom of Morgan Stanley’s assessment of 26 European banks.
(Source: Yahoo/Reuters, June 14, 2016, “Deutsche Bank, UniCredit AT1 coupons most at risk -analysts”)
Using more stringent criteria than the usual “stress tests” reveals a more realistic assessment of banking hazards in European banks but particularly DB:
Assessing the real risk of a DB illiquidity failure leading to a catastrophic outcome:
On the same page, Deutsche reports the net market value of its derivatives book: €18.3 billion, only 0.04 percent of its notional amount. However, this figure is almost certainly an under-estimate of Deutsche’s derivatives exposure.
It is unreliable because many of its derivatives are valued using unreliable methods. Like many banks, Deutsche uses a three-level hierarchy to report the fair values of its assets. The most reliable, Level 1, applies to traded assets and fair-values them at their market prices. Level 2 assets (such as mortgage-backed securities) are not traded on open markets and are fair-valued using models calibrated to observable inputs such as other market prices. The murkiest, Level 3, applies to the most esoteric instruments (such as the more complex/illiquid Credit Default Swaps and Collateralized Debt Obligations) that are fair-valued using models not calibrated to market data — in practice, mark-to-myth. The scope for error and abuse is too obvious to need spelling out. P. 296 of theAnnual Report values its Level 2 assets at €709.1 billion and its Level 3 assets at €31.5 billion, or 1,456 percent and 65 percent respectively of its preferred core capital measure, Tier 1 capital. There is no way for outsiders to check these valuations, leaving analysts with no choice but to work with these numbers while doubtful of their reliability.
(Source: Cato Institute, Kevin Dowd, August 4, 2016, “Is Deutsche Bank Kaputt?”)
Simply, under crisis conditions where liquidation of derivative positions is both mandatory and urgent, the “theoretical” collateral values will not be honored by counterparties; counterparties that play in the derivatives game are experienced operators knowing full well the hollowness of opaque collateral of which there is no market for, on par with the demand for lepers. The cold truth of the matter is that “marked-to-fantasy assets” only are viable under serene market conditions and only bear merit to appease shareholders and regulators in the pacific realm of spreadsheets. However, when market conditions are turbulent the bid for skeptically-valued assets will vanish exposing the hidden risk of a dangerously undercapitalized bank such as DB. But in the case of DB, due to the labyrinth and massiveness of interconnections that strike not only Europe but across the pond, this then becomes a geopolitical-level problem on the front page of the global stage, a gray swan event unfolding:
The 2.71 percent leverage ratio is a book value estimate. Corresponding to the book-value estimate is the market-value leverage ratio, which is the estimate reflected in Deutsche’s stock price. In the present context, the latter is the better indicator, because it reflects the information available to the market, whereas the book value merely reflects information in the accounts. If there is new information, or if the market does not believe the the accounts, then the market value will reflect that market view, but the book value will not.
One can obtain the market value estimate by multiplying the book-value leverage ratio by the bank’s price-to-book ratio, which was 44.4 percent at the end of 2015. Thus, the contemporary market-value estimate of Deutsche’s leverage ratio was 2.71 percent times 44.4 percent = 1.20 percent.
Since then Deutsche’s share price has fallen by almost 43 percent and Deutsche’s latest market-value leverage ratio is now about 0.71 percent.
(Source: Cato Institute, Kevin Dowd, August 4, 2016, “Is Deutsche Bank Kaputt?”)
DB offered in May-June 2016 a 5% return on fixed deposits held for 90 days in Belgium and currently 8.5% in India. In today’s zero-bound interest rate climate, a healthy world-class bank has no reason to do this.
Deutsche Bank had been advertising a 5% interest rate to customers in Belgium on 90-day deposits of at least 50k euros. Bank deposits are essentially “loans” to a bank from the depositor (creditor). This implies that the rate that DB had to pay to attract deposits is equivalent to a triple-C rated credit (although the 10-yr junk bond rates for double-B rated bonds are around 5.5%, keep in mind that DB is paying 5% for 3-month money). This is the unmistakable sign of a company that is collapsing.
(Source: investmentresearchdynamics.com, June 14, 2016, “Deutsche Bank Is Collapsing — But It’s Not The “Black Swan”)
General context in Germany and Europe: Evidence of stealth bank runs on European banks (Note: non-specific to DB, this is a general trend that could go vertical and is on the Prevailing Gray Swan Depth Chart)
”The other evidence of banking woes is the flight of investment capital into government bonds from cash and deposits held within the banking system, so much so that Germany’s 10-year bond now carries a negative redemption yield. The flight into tangible bonds is so pronounced, that €400bn of investment grade corporate bonds are also on negative redemption yields. Market commentators are blaming this on fear of Brexit, but one look at the financial condition of the European banks tells us a different story. The banks must be struggling with deposit contraction on their balance sheets, fueled by a combination of negative interest rates and systemic fears, at a time when their loan books are burdened with bad and irrecoverable debts. It looks like the modern equivalent of an old-fashioned run on the banking system, led by the pension and insurance companies, which are becoming increasingly concerned about leaving balances with the banks.”
(Source: financeandeconomics.org, Alasdair McLeod, June 18, 2016,“Brexit is getting the blame”)
Trust is being lost in the European banking system and in governments; the tip of the spear are the tiny few with wisdom, caution, and history roaming their minds late at night. Such people are fiduciaries at insurance and pension companies and hedge funds and in their social circles they rub shoulders with bankers. After the tip of the spear the word will reach smart investing firms with common sense, CFOs responsible for payroll disbursement, and high networth individuals and their advisors — they are awake, they sense their cash on deposit is vulnerable. Finally it filters down to the last-to-know: the rank-and-file.
The bail-in threat is flashing red: the European banking system is fraught with hidden risk. Take note that the leading indicator of bank runs is no longer long lines going around the block — that is the trailing indicator and by that time is gated to pocket change.
Domestically, the largest German banks and insurance companies are highly interconnected (Figure 14). The highest degree of interconnectedness can be found between Allianz, Munich Re, Hannover Re, Deutsche Bank, Commerzbank and Aareal bank, with Allianz being the largest contributor to systemic risks among the publicly-traded German financials. Both Deutsche Bank and Commerzbank are the source of outward spillovers to most other publicly-listed banks and insurers. Given the likelihood of distress spillovers between banks and life insurers, close monitoring and continued systemic risk analysis by authorities is warranted.
(Source: IMF report on Germany, June 2016, p. 29)
There has been an attempt to merge with Germany’s second biggest bank Commerzbank but the deal was aborted:
This weekend, senior executives are meeting to debate some of these options, according to people familiar with the plans. One has already been floated: a merger with Germany’s second-largest bank by market value, CommerzbankAG, the people said. The two banks in August held preliminary discussions about a tie-up, before concluding last week it wasn’t viable.
(Source: Wall Street Journal, August 31, 2016, “Deutsche Bank Weighs Stronger Medicine: Under consideration: sale of key asset-management unit. Rejected: merger with Commerzbank”)
Deutsche Bank is a threat to the global banking system and the consequences of a potential bankruptcy greatly exceeds the Bear Sterns and Lehman Brothers collapse aftermath in 2008 due to DB’s vast scale of derivatives’ exposure and equity status matched-up to the fragility of a multitude of interconnected banks in Europe — the European banking system is a cross between a tinderbox and a triage. Unlike 2008, the DB threat cannot be assessed and managed solely from economic and financial perspectives, social and political factors weigh-in heavily because the world learned first-hand the visceral meaning of “systemic bank collapse.” Ergo — now — “we the people” would lose all trust in the banking system and government if this were to happen so it won’t simply because the world’s governments cannot afford the loss of the tenuous remnants of credibility capital.
The likelihood of DB undergoing formal bankruptcy proceedings are remote because the consequences are globally dire — truly a weapon of mass financial destruction. The most likely actions will take place out of the public eye so that trust is preserved in the system and “the system” means the sum of publicly-traded banks, governments, and central banks and would extend beyond the original purview of the ECB and include the US Federal Reserve/Treasury Department if required just like in 2008. In the case of DB’s failure, “whatever it takes” would take a lot more than what Berlin and the ECB can deliver. Just because there is no news in no way reflects lack of action including action of Herculean magnitude and/or unprecedented measures behind the curtain. Beyond a band-aid approach composed of a series of “loans” and currency swaps (i.e. “stealth bail outs”), an intelligent solution to stabilize the predicament more permanently would be for Germany to nationalize DB in the form of a merger with German’s central bank, Deutsche Bundesbank, which would offer the unique opportunity to restructure DB from the ground up while becoming Siamese twins both literally and figuratively with the ECB whose European headquarters is conveniently located in Berlin. This assumes the essence of the headquarters of the acquired (DB in Frankfurt) would be assimilated in Berlin.Nationalizing distressed banks in Europe has been a successful expedient previously and will become warranted here.
Synergistically, this arrangement of the gravitational pull of the European Central Bank + Deutsche Bank + Deutsche Bundesbank triumvirate would attract many other international banks with the eventual ecosystem perhaps achieving a level that would rival a waning London bank complex post-Brexit. Too out-of-the-box? No. Not given the risks and rewards on the event horizon. The potential carnage, strategic upside, and grand stakes for those in high places with more than skin in the game is palpable. If DB’s collapse is not grabbed by the horns early enough it could be a runaway truck. Prevention kills two birds with one stone but the story and timing need to be well orchestrated. Establishment of urgency would not be a fabrication and would provide the basis of a strong case for taking drastic pre-emptive action.
Prudent Actions to Strongly Consider
Immediate withdrawal of all funds that could be subject to a bail-in. DB suffering a bail-in is an unlikely event — all things considered — but givenChancellor Merkel’s sharp verbal directives toward Italian Prime Minister Matteo Renzi in regards to there being no bail-outs for Italian banks, it is wise to respect the unassailable wisdom of “what is good for the goose is good for the gander.” This could embarrassingly backfire on Merkel. But in any case, money on deposit at DB is at risk of confiscation because we live in dangerous times. Yes, confiscation could happen even given the overwhelming evidence for avoiding it at all costs. Big picture on DB: being prepared for gray swans is one thing, being aware of black swans is quite another. And — rest assured — they are out there flying around the Black Forest.
Prepared by: James Autio
Other substantive opinions
Dissenting perspective: Why DB will be able to survive without intervention, August 29, 2016, (Source: Value Walk, Caleb Gibbons, “DEUTSCHE BANK — HERE BE DRAGONS, NOT”)
“Chart: The Epic Collapse of Deutsche Bank” (excellent tutorial infographics of the DB collapse in progress) (Source: VisualCapitalist)
Argument that something besides derivative exposure is the cause of DB’s collapse (Source: Mish Shedlock)
“Panic Early, Beat the Rush” (Source: Lewis Johnson, Capital Wealth Advisors)